Sunday, June 27, 2010

What is Money? A Short Analysis

The subject of money seems to cause people a considerable amount of confusion. What it is and what it does can be difficult concepts for some people.

This is a very short analysis.

My view is that money can be best understood through these four propositions:
(1) Money is (a) a unit of account, (b) a medium of exchange and (c) a store of value;

(2) Money is a present and future potential claim on (a) commodities (goods and services), (b) assets (real or financial), and (c) foreign exchange (e.g., other currencies);

(3) Money’s role in proposition (2) can be foregone and money can be saved for a return for specific periods in whole (e.g., certificates of deposit, time deposits and other investments) or in part in a more flexible way (e.g., demand deposits or savings accounts) and lent out to other people;

(4) Money is also a thing that can be used to discharge one’s obligations (e.g., debt, taxes, fines, or compensation one might be obliged to provide).
In my view, propositions (1) to (4) are a good fundamental description of what money is and does. It is of course hardly complete or exhaustive. For example, some people choose to hold money in its own right (say, by hoarding it) rather than saving or investing it, or as a security against uncertainty in the future, or for the sake of status and the privileges that one can obtain by holding large amounts of money. Money can also be considered as the most liquid asset, and in this latter role demand for money itself can be an important factor in economic activity, as the liquidity preference theory of Keynes shows. Moreover, the theory of how money actually historically arose is still debated by neoclassical economists and chartalists/neo-chartalists (I am personally sympathetic to the chartalist theory on the origin of money).

As a supporter of Post Keynesianism, I advocate fiat money as preferable to commodity money, and view the modern money supply as essentially endogenous (in contrast to the “exogenous” money supply view). Furthermore, money is not some veil over an economy where economic activity is essentially barter: money has real effects on economic activity and is not neutral.
I will briefly examine each of my four propositions in more detail below.

I. (1) Money is (a) a unit of account, (b) a medium of exchange and (c) a store of value
These are money’s fundamental functions and the answer you usually get to the question of what money is.

As a unit of account, money is a thing by which we measure the value of another thing such as a commodity, asset or obligation. We can measure the relative values of one commodity/asset against another commodity/asset as well. Money is thus a common unit of measurement by which we establish value and compare it.

The medium of exchange function means that money is the intermediary instrument we use to buy, sell and trade commodities and assets. This avoids the highly inefficient system of bartering goods and services used in the past. The medium of exchange function makes market exchange much more efficient, rapid, and convenient. The neoclassical view is that the medium of exchange role arose as one commodity (usually gold or silver) become the most marketable good in the community. Chartalism, by contrast, emphasises the role of states in creating money by creating a “money thing” (often silver or other metal coins) that the government then demanded back as payment for taxes levied on the community. This had a fundamental role in creating the medium of exchange function of money.

The store of value function means that money has the power to store its value for a short or long time. With fiat money, the value of money essentially comes from its purchasing power (its power to buy a given quantity of commodities or assets). Inflation erodes this power, but since "store of value" is only one function of money one will have to decide whether the trade-off between the positive effects that inflation can have (or be an effect of) and the lower purchasing power for money that results is justified. If we avoid crippling debt deflation and productive borrowers benefit (at the expense of non-productive rentiers), then low and steady inflation can be fullly justified.

II. (2) Money is a present and future potential claim on (a) commodities (goods and services), (b) assets (real or financial), and (c) foreign exchange
Our money allows us to buy commodities (goods and services) and assets.
Some people might wonder why I have added a third item: foreign exchange.
Demand for foreign exchange is important: importers of foreign goods need it as well as domestic investors wishing to own foreign assets. The world’s reserve currency is the US dollar, which can be a potential claim on the commodities and assets in nearly all countries. There exists a precautionary demand for foreign currency too in trade, as well as a demand for it in financial markets. Foreign exchange allows a good many international financial transactions including speculation in financial assets and derivatives markets. A vast amount of economic activity involves “hot money” flowing in and out of nations and used in such financial transactions and often just moved around endlessly between nations for this purpose. I would consider the claim on foreign exchange to be a legitimate third claim that money has.

III. (3) Money foregone through saving
We can defer our purchasing of commodities and assets today, and instead obtain a return on money by lending it through saving. Very rich people in fact simply invest most of their wealth in this way. They have no interest in ever claiming output with all of it. Instead, they can get a good annual income through investing their excess savings and keeping that money invested for long periods (e.g., in perpetual trust funds).

IV. (4) Money is also a thing that can be used to discharge one’s obligations (e.g., debt, taxes, fines, or compensation one might be obliged to provide).
This is a very important function as people must pay taxes and debt. Historically, government taxes were a cause of the origin of money. As L. R. Wray has argued:
the evolution of money is linked to the needs of the state to increase its power to command resources through monetization of its spending and taxing power. Thus, money and monetary policy are intricately linked to political sovereignty and fiscal authority …. the critical point is that governments impose fees, fines, and taxes to move resources to the government sector, and that for many thousands of years, governments have imposed these liabilities in the form of a monetary liability. Originally, the money liability was always in terms of a unit of account as represented by a certain number of grains of wheat or barley … Once the state has imposed the tax liability, the taxed population has got to get hold of something the state will accept in payment of taxes. This can be anything the state wishes: It can be clay tablets, hazelwood tallies, iron bars, or precious metal coins. This, in turn, means the state can buy whatever is offered for sale merely by issuing that thing it accepts in payment of taxes. If the state issues a hazelwood tally, with a notch to indicate it is worth 20 pounds, then it will be worth 20 pounds in purchases made by the state so long as the state accepts that same hazelwood stick in payment of taxes at a value of 20 pounds. And that stick will circulate as a medium of exchange at a value of 20 pounds even among those with no tax liability so long others need it to pay taxes .... The modern Post Keynesian view of money is based on a neo-Chartalist, or state money, approach (Wray 2000).
If you look at a US one dollar bill, you will see the words “this note is legal tender for all debts, public and private.” Chartalists contend that it was this role created by government that is the key to money’s origin and development.

V. Commodity versus Fiat Money
Until the 1930s, commodity standards were a major form of money. A commodity money system is one where some commodity (e.g., gold or silver) is the basic form of money. It is “money proper.” “Money substitutes” are used in place of it, but must be convertible into the commodity at some fixed rate on demand.

Fiat money, by contrast, is money created by government acceptable for payment of taxes and debt through “legal tender” laws. Fiat money is not convertible into a commodity on demand at a fixed price and its supply is not limited. Fiat money has the advantage of freeing the monetary system from crippling unexpected deflation that causes debt deflation and has devastating effects on economic activity. I favour fiat money, with floating exchange rates (but where there is some scope for central bank intervention to prevent excessive appreciation or depreciation of the currency).

The classical gold standard was the most obvious example of a commodity standard. Yet as I have pointed in my previous post (see Fractional Reserve Banking: An Evil?), the gold standard imagined by some Austrian economists is a myth. In fact, by 1913 paper currency and bank deposits accounted for 90% of overall currency circulation in the world, and actual gold itself for not much more than 10% (Triffin 1985: 152). And this was the “classical” gold standard! It was a world where fiduciary media like credit money had become the major type of money in the broad money stock by the late 19th century. The reason is that, under the gold standard, there was a need for increasing creation of fiduciary media (a type of “money substitute”) like credit money, because not enough gold existed to meet the demands of the community for money. Fiduciary media are “money substitutes” in excess of the actual amount of commodity money (or “money proper”). Most “free banking” libertarians do not object to such “fiduciary media” per se, but the branch of Austrian economics influenced by Murray Rothbard does.

Modern Austrians and libertarians still debate the question whether increasing issues of fiduciary media (under a commodity system) were (1) unacceptable “created credit” (which allegedly causes “forced savings”) or (2) legitimate “transfer credit.” Ludwig von Mises’s view on fiduciary media, for example, was not wholly consistent. In his Theory of Money and Credit, Mises seems to suggest that increases in fiduciary media caused by a corresponding demand could be non-inflationary and presumably acceptable (Horwitz 2000: 78). In his later writings, however, he condemned the issue of fiduciary media uncovered or only partially covered by commodity money as a type of “created credit.” The “created credit” would increase the broad money stock, raising money prices and redistributing resources in favour of the first recipients of the money (Hülsmann 2007: 249).

As I have shown in the last post (see Fractional Reserve Banking: An Evil?), the Rothbardian view that fractional reserve banking and fiduciary media are immoral is utterly unconvincing.

As an advocate of Post Keynesian economics, I would also argue that the innovation by which investment could be increased beyond savings through fractional reserve banking and fiduciary media was a powerful method of increasing real economic growth through production of more goods and services and more productive investments.

That the “first recipients” of “created credit” were able to obtain a redistribution of resources in their favour was and is fully justified, if these people were engaged in productive investment that will benefit society as a whole and make it wealthier. And this just underscores the need for careful and effective financial regulation that can prevent asset bubbles and channel investment to productive uses.

The higher inflation that might (or might not even) happen is the trade-off you get from faster economic growth. And in fact as I show here (see The Austrian Theory of Inflation: Myths and Reality), the Austrians are committed to the view that changes in the level of prices depend very much on both real factors and monetary ones. In reality, whether inflation happens or not could be determined by real factors. Such real factors that can overwhelm monetary factors and keep inflation low include:
1. the falling prices of specific goods through increasing productivity or output;
2. low capacity utilization rates;
3. a rise in cheaper imports into a country;
4. falls in the prices of imported basic commodities that are factor inputs;
5. changes in the velocity of circulation of money, and
6. level of employment (= level of demand for goods and services).
Whether you get inflation or not when fiduciary media are issued (or, for that matter, fiat money) depends on the particular state of the economy at that time. I also see no argument against increasing credit money in line with the demand for it in a fiat currency system with effective financial regulation.

VI. Some Other Issues
The subject of money is frequently raised on the Cynicus Economicus blog by commentators.

Recently, one commentator has argued:
the prevailing theory here is that money is a representation of the value of goods and services currently exchanged within an economy.
But this is a definition of GDP, not money.
Also, another comment:
If money is created without a corresponding increase in goods and services then it naturally devalues what each note can buy. That’s inflation.
This assumes that the quantity theory of money – the idea that there is a direct, mechanistic relationship between the money supply and the inflation rate/price level. But the quantity theory makes assumptions that are either (1) fundamentally false or (2) untrue in recessions. The quantity theory assumes this:
1. a stable velocity of circulation;
2. an exogenous money supply, and
3. high capacity utilization/high employment.
In reality, we have an essentially endogenous money supply, so assumption (2) is wrong.

The velocity of money is unstable and subject to shocks and moves pro-cyclically (Leo 2005), and in a recession capacity utilization is low. The quantity theory also ignores imports in open economies, which can keep inflation low.

Another commentator called Sobers remarks:
Money is just a store of labour – a way of translating today’s production into tomorrow’s consumption with the maximum efficiency. I dig my neighbour’s garden, he gives me £20. I may put it in my bank and save it for a rainy day, or I may spend it down the pub immediately. It’s my choice. It was my labour.
This idea is based on the view that value can only come from a subjective valuation of the underlying labour used to produce something.

But this “subjective labour theory of value” is deeply flawed. When people buy commodities, they do not all simply “subjectively value labour.” The subjective decision to buy something could be based on one, two, or many factors that have nothing whatsoever to do with the subjective value of the underlying labour.

If you find even one instance of someone buying a commodity where his or her subjective decision had no role for a subjective valuing of labour, the theory would not work.

And, of course, in reality, many people do consume commodities without the slightest interest in the subjective value of the underlying labour.

If I purchase a pearl at a market, I do so because I find the pearl aesthetically pleasing. I have no interest in the subjective value of the labour it took to bring the pearl to market (about which I know nothing anyway), and a subjective “labour valuation” is utterly irrelevant to the question whether I find it aesthetically pleasing or not.

If the “subjective labour theory of value” collapses, then so too does the idea that money is just a store of labour.


Horwitz, S. 2000. Microfoundations and Macroeconomics: An Austrian Perspective, Routledge, London and New York.

Hülsmann, J. G. 2007. Mises: The Last Knight of Liberalism, Ludwig von Mises Institute.

Leo, P. 2005. “Why does the Velocity of Money move Pro-cyclically? International Review of Applied Economics 19.1: 119–135.

Triffin, R. 1985. “Myth and Realities of the Gold Standard,” in B. Eichengreen and M. Flandreau (eds), The Gold Standard in Theory and History, Routledge, London and New York. 140–161.

Wray, L. R. 2000. “The Neo-Chartalist Approach to Money,” Center for Full Employment and Price Stability


  1. An aspect about 'what is money', that you might like to consider apart from your aademic analysis, is that money is used as a reward. That simple premise ultimately explains the behaviour of money.

    Money is given and demanded as the reward for skills, work and even just lending money!. It is essentially motivational, both out of necessity and greed.

    Money is only important in that it can be changed into something of real value to the individual, whether it be food or Chelsea football club.

  2. Mr Welldodgy,

    Thanks for your comment.
    You are undoubtedly correct that "reward" is an element that explains many uses of money.

    But the other side of the coin is "obligation" or even "punishment": e.g., debt, taxes, fines, compensation.

    As I have said above, chartalist theory shows us that there is good reason to believe that state imposition of taxes had a major role in creating money function as a medium of exchange.


  3. This comment has been removed by the author.

  4. Question:

    You write that money can be...

    "occasionally by unconventional means such as monetising a budget deficit."

    My question is...if the Central Bank were to simply credit the Treasury's General Account out of no where, without that money going into the that an example of exogenous money creation since it's not demanded by the public??

    Also then, suppose Congress appropriates a certain sum of that created money to build a battleship...without taxes or endogenous money obtainted from a debt instrument...

    Would that be an example of the U.S. causing real production funded by an injection of Exogenous money into, say, Newport News Shipbuilding's Checking Account in exchange for their building a battleship?